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The Economicsof Information
The Economicsof Information
Chapter 13: The Economics of Information Slide 2
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Introduction
The invisible hand theory assumes that buyers are fully informed.
Given that consumers are not fully informed, they must employ strategies for gathering information.
Chapter 13: The Economics of Information Slide 3
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
How the MiddlemanAdds Value
ExampleHow should a consumer decide which pair
of skis to buy?Skis R Us has a.......
o knowledgeable sales staffo and a large inventory
They Recommend Salomon X-Scream 9 skis for $600
Chapter 13: The Economics of Information Slide 4
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
How the MiddlemanAdds Value
ExampleHow should a consumer decide which pair
of skis to buy?The skis can be purchased on the Internet for
$400
QuestionIs spending $600 on the right skis better
than $400 on the wrong ones?
Chapter 13: The Economics of Information Slide 5
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
How the MiddlemanAdds Value
How does better information affect economic surplus?Ellis wants to sell a Babe Ruth baseball
card.His reservation price is $300.An ad in the local newspaper cost $5.eBay cost is 5% of the Internet auction price.The maximum price in the local market is $400.
Chapter 13: The Economics of Information Slide 6
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
How the MiddlemanAdds Value
ExampleHow does better information affect
economic surplus?The maximum prices in the eBay market is
$900 and $800.Economic surplus:
o Local market = $400 - $5 - $300 = $95o eBay = $800 - $40 - $300
= $460 + $100 = $560
Chapter 13: The Economics of Information Slide 7
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
How the MiddlemanAdds Value
ExampleHow does better information affect
economic surplus?Economic surplus is increased when a product
goes to the person who values it the most.
Chapter 13: The Economics of Information Slide 8
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
The Optimal Amountof Information
$/u
nit
Units of information
Marginal costof information
Marginal benefitof information
I *
The optimal amount ofinformation (ignorance)occurs where MC = MB
Chapter 13: The Economics of Information Slide 9
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
The Free Rider ProblemAn incentive problem in which too little
of a good or service is produced because nonpayers cannot be excluded from using it
The Optimal Amountof Information
Chapter 13: The Economics of Information Slide 10
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Economic NaturalistWhy is finding a knowledgeable salesclerk
often difficult?Why did Rivergate Books, the last
bookstore in Lambertville, NJ, recently go out of business?
The Optimal Amountof Information
Chapter 13: The Economics of Information Slide 11
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Two Guidelines for Rational SearchAdditional search time is more likely to be
worthwhile for expensive items than cheap ones
Prices paid will be higher when the cost of a search is higher
The Optimal Amountof Information
Chapter 13: The Economics of Information Slide 12
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
ExampleShould a person living in Paris, Tx, spend
more or less time searching for an apartment than someone living in Paris, France?
The Optimal Amountof Information
Chapter 13: The Economics of Information Slide 13
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
ExampleTom and Tim are shopping for a used
upright piano.Tom has a car & Tim does not.Which one should expect to examine fewer
pianos before making a purchase?
The Optimal Amountof Information
Chapter 13: The Economics of Information Slide 14
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
The Gamble Inherent in SearchWhen engaging in further search there are
additional costs and uncertain benefits and, therefore, there is a degree of risk or gamble from the search.
The Optimal Amountof Information
Chapter 13: The Economics of Information Slide 15
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Determining whether or not to take the gamble:Compute the expected value of the gamble
The sum of the possible outcomes multiplied by their respective probabilities
The Optimal Amountof Information
Chapter 13: The Economics of Information Slide 16
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Determining whether or not to take the gamble:Fair Gamble
Coin flip: Heads win $1, Tails lose $1Expected value = (.5)($1) + (.5)(-$1) = 0
The Optimal Amountof Information
Chapter 13: The Economics of Information Slide 17
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Determining whether or not to take the gamble:Better-than-fair-gamble
Coin flip: Heads win $2, Tails lose $1Expected value = (.5)($2) + (.5)(-$1) = .5
The Optimal Amountof Information
Chapter 13: The Economics of Information Slide 18
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Determining whether or not to take the gamble:Risk-neutral person
Will accept any gamble that is fair or better
Risk-averse personWill refuse any fair gamble
The Optimal Amountof Information
Chapter 13: The Economics of Information Slide 19
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
ExampleShould you search further for an
apartment?Searching for an apartment in a neighborhood
where identical apartments rent for $400 & $360
Of the vacant apartments, 80% rent for $400 and 20% rent for $360
You must visit the apartment to get the rental rate
The Optimal Amountof Information
Chapter 13: The Economics of Information Slide 20
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
ExampleShould you search further for an
apartment?The first visit is a $400 apartment.The opportunity cost of an additional visit is $6.
The expected value of another visit:(.2)($34) + (.80)(-$6) = $2
The Optimal Amountof Information
Chapter 13: The Economics of Information Slide 21
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
The Commitment Problems When Search is CostlyWhat happens when, by chance, a more
attractive option comes along after the search has ceased?
The Optimal Amountof Information
Chapter 13: The Economics of Information Slide 22
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
The Commitment Problems When Search is CostlyWhen information is costly and the search
must be limited, a relationship may dissolve.
The Optimal Amountof Information
Chapter 13: The Economics of Information Slide 23
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
The Commitment Problems When Search is CostlyCommitment agreements
Lease agreementsEmployment contractsMarriage contracts
The Optimal Amountof Information
Chapter 13: The Economics of Information Slide 24
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
Asymmetric InformationSituations in which buyers and sellers are
not equally well informed about the characteristics of goods and services for sale in the marketplace.
Chapter 13: The Economics of Information Slide 25
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
ExampleWill Jane sell her car to Tom?
Chapter 13: The Economics of Information Slide 26
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
ExampleWill Jane sell her car to Tom?
AssumeJane wants to sell a 2001 Miata
70,000 highway milesComplete maintenanceExcellent conditionAverage price is $8,000Jane’s reservation price is $10,000
Chapter 13: The Economics of Information Slide 27
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
TomReservation price
$13,000 if in excellent condition$9,000 if not in excellent condition
Will not pay $10,000 because he cannot tell if Jane’s car is an excellent buy
Tom buys an average car
Chapter 13: The Economics of Information Slide 28
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
ExampleThere is a loss in economic surplus
Assuming Tom had paid Jane $11,000
Chapter 13: The Economics of Information Slide 29
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
ExampleTom
Pays $8,000 and has a gain of $1,000 ($9,000 - $8,000)
Tom’s Losso $13,000 - $11,000 = $2,000 - $1,000 = $1,000
Jane’s loss is $1,000Total loss is $2,000
Chapter 13: The Economics of Information Slide 30
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
The Lemons ModelAsymmetric information tends to reduce
the average quality of goods offered for sale.
Chapter 13: The Economics of Information Slide 31
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
The Lemons ModelPeople who have below average (lemons)
cars, are more likely to want to sell them.Buyers know that below average cars are
likely to be on the market and lower their reservation prices.
Chapter 13: The Economics of Information Slide 32
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
The Lemons ModelBecause used car prices are low, people
with good cars keep them longer.The average quality of used cars falls even
further.
Chapter 13: The Economics of Information Slide 33
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
ExampleShould you buy your aunt’s car?
4-year old AccordThe asking price of $10,000 is the blue book
value.You believe the car is in good condition.It is a good deal because the blue book value is
the equilibrium price for below average cars.
Chapter 13: The Economics of Information Slide 34
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
ExampleHow much will a naïve buyer pay for a
used car?
Chapter 13: The Economics of Information Slide 35
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
AssumeThere are only good cars and lemons.10% of all new cars are lemons.Good used cars are worth $10,000 and
lemons are worth $6,000.The used car market is 90% good cars and
10% lemons.
Chapter 13: The Economics of Information Slide 36
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
ExampleCalculating the expected value:
(.90)($10,000) + (.10)($6,000) = $9,600o Reservation price for a risk-neutral buyer
Chapter 13: The Economics of Information Slide 37
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
ExampleWho will sell a used car for what the naïve
buyer is willing to pay?Would not sell a good car that is worth $10,000Would sell a lemon that is worth $6,000Only lemons will be on the marketPrice will fall to $6,000
Chapter 13: The Economics of Information Slide 38
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
What Do You Think?If you have a good used car for sale, how
can you get a higher price?
Chapter 13: The Economics of Information Slide 39
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
The Credibility Problem In TradingPeople tend to interpret ambiguous
information in ways that promote their own interests.
Chapter 13: The Economics of Information Slide 40
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
The Costly-to-Fake PrincipleTo communicate information credibly, a
signal must be costly or difficult to fake.
Chapter 13: The Economics of Information Slide 41
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
Economic NaturalistWhy do firms insert the phrase “As
advertised on TV” when they advertise their products in magazines and newspapers?
Why do many companies care so much about elite educational credentials?
Chapter 13: The Economics of Information Slide 42
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Conspicuous Consumptionas a Signal of Ability
Economic NaturalistWhy do many clients seem to prefer
lawyers who wear expensive suits?
Chapter 13: The Economics of Information Slide 43
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
Statistical DiscriminationThe practice of making judgments about
the quality of people, goods, or services based on the characteristics of the groups to which they belong.
Chapter 13: The Economics of Information Slide 44
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
Economic NaturalistWhy do males under 25 years of age pay
more than other drivers for auto insurance?
Chapter 13: The Economics of Information Slide 45
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
Adverse SelectionThe pattern in which insurance tends to be
purchased disproportionately by those who are most costly for companies to insure
Chapter 13: The Economics of Information Slide 46
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
Adverse SelectionRaises premiumsReduces the number of low-risk policy
holdersIncreases the risk level of the insured
Chapter 13: The Economics of Information Slide 47
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
Moral HazardThe tendency of people to expend less
effort protecting those goods that are insured against theft or damage
Chapter 13: The Economics of Information Slide 48
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Asymmetric Information
Moral HazardDeductibles are used to reduce moral
hazard and adverse selection.Lower ratesIncrease the incentive to drive safelyReduce the number of claims, which lowers
cost and premiums
Chapter 13: The Economics of Information Slide 49
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Disappearing Political Discourse
Economic NaturalistWhy do opponents of the death penalty
often remain silent?
Chapter 13: The Economics of Information Slide 50
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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.
Disappearing Political Discourse
Economic NaturalistWhy do proponents of legalized drugs
remain silent?
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End ofChapterEnd of
Chapter
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